When it comes to trading decision process rational human reasoning is not an advantage. Exactly, in many instances it will lead to wrong decisions. As a result you will most likely end up with suboptimal returns. It is determined that we can categorized two main sources of average people’s decision abilities when you put them in trader’s shoes.
First group is related to Emotional Biases. It is that spontaneous impulse that you, for instance, had when you bought your first car with your own salary. You earned that money by yourself. That car has the greatest value for you, no matter what market says. At the end, what does anyone know about driving that nice car in your home town that brings all the good memories from your 20es.
When we talk about trading emotionalism there are certainly different aspects of it.
- Loss-Aversion is well known to any trader. We just hate to loss. Pain of loss is greater than pleasure of equivalent gain. Many of us held losers for too long. You feel it is not real loss until you sell the stock for less than you paid, or is it? This is known as disposition effect.
- Overconfidence is illusion of knowledge. After all, it is always easier to be a general after the battle. Traders are prone to overstate accuracy of their estimates. This can lead to under estimate of risk and over trading.
- Endowment bias is propensity to value an asset that is owned more highly than the same asset that is not owned. This is followed by failing to make appropriate asset sales.
- Regret Aversion is tendency to make no decision. By doing so you ignore errors of omission. This could result either in too much risky or conservative portfolio.
Second group is known as Cognitive Errors. It is basically related to false way of thinking, reasoning and limited memory. In simple words we are not computers. We like to think of ourselves as perfect rational beings, but never the less, we are often prone to mistakes. Cognitive errors are related to believe perseverance and information processing biases.
Believe perseverance is irrational adherence to faulty beliefs and is commonly related to memory issues or falling to update probabilities. You can find this type of trader behavior in different forms.
- Anchoring and adjustment is tendency to too much focus on initial anchor point, which leads to insufficient adjustment when new information comes, either in an up or a down trend.
- Mental accounting is propensity to treat money differently based on how it is categorized. For instance, it is in line with next statement: “I would like to use dividend yield for current living expenses and never capital gains.”
- Framing might be the most interesting phenomenon by itself. Hence, only with different formulation of question you will get two opposite answer to a basically same question.
- Availability is term used for estimating probability based on how easy you can recall facts.
Information processing biases is associated with illogical or irrational use of information.
- Conservatism is tendency to maintain initial information in any case, even if new information is contradictory.
- Confirmation means that you will be prone to find evidence in any new information to support your initial view.
- Representativeness is related to classification of new evidence based on past experience or classification, without examination.
- Illusion of control is exactly what the name implies. The trader believes that he possesses ultimate market wisdom. In many cases that can lead to excessive treading which translates into high transaction costs.
- Hindsight is best described with this quote: “I only remember what I want to remember.” Basically you end up with false comfort in your forecasting based on this selective memory approach.
Can You Be Less Human?
In short yes more precisely, at least partially.
Generally it is easier to overcome cognitive errors than emotional biases. You can educate yourself about the probability theory and that way have an advantage and a chance of beating the market. However, it has been proven that it is harder to overcome emotional biases.
Nice. Thanks for the post.
You are welcome Michael
Good point. It is funny how we perceive dividends and capital gains in a different ways. Psychology definitely plays a major role in the trading.
Absolutely Behavioral Finance is becoming mainstream.
thanks Boris, appreciate that you are sharing this
You welcome Ethan
I guess we can relate this to the right and left side of the brain. That can at least partially explain why it is easier to overcome rational constraints than irrational ones.
Thanks for the comment. Neuroeconomics suggests that.
Great post. thanks
You are welcome Michael
Well explained. Thank you.
Thank you Rod.